Everything You Know Is Wrong

June 8, 2011 | The Skeptical Outsider | I’m new to your neighborhood, a refugee from the telecommunications and semiconductor industries where I spent the last thirty years living under the relentless Darwinian pressure of Moore’s Law: better, faster, cheaper, or die. Examining your world of drug development, medical practice, and health care delivery in what economists euphemistically call a “mixed economy” will be a bit of an Alice-through-the-looking-glass experience. With your forbearance I’d like to ask some questions, and share some wonder and dismay. Maybe we’ll both learn something.

This doesn’t mean good things aren’t happening somewhere. The world will never run out of smart people no matter how tightly you chain them down. On a systemic level, though, can anyone doubt that it is getting harder to bring innovation to the health care market here in the U.S.? If fundamental changes aren’t made it may become impossible.

Where to start? “Begin at the beginning and go on till you come to the end: then stop,” said the King to Alice.

The Information Problem

Efficiently coordinating the activities of millions of inventors, producers, consumers, and investors who create and exchange value across multiply interlinked and temporally varying global supply chains is incomprehensibly complex. The resulting information flux is far too large to be digested by any one person or committee, even with the help of a supercomputer.

Yet no other major industry attacks the problem the way the health care industry does. That’s because the rest of us rely on this incredible data reduction tool, a shorthand of sorts, that lets us concentrate and deliver the most relevant and actionable information wherever it is needed most. Economic systems that rely on this shorthand are far from perfect. But history has shown them to be unmatched for delivering the greatest good to the greatest number. That shorthand is called… a price.

You don’t have prices in the health care industry, not really. Not like we do in other industries where the price of something as well as its trajectory over time embodies critical information about supply, demand, profit opportunities, cost reduction imperatives, substitution incentives, resources allocation clues, investment signals, market entry inducements, and countless other things that make industries efficient.

You health care folks have sovietized your pricing system to an extent that hasn’t been seen since, well, the Soviet Union. Do you understand how this has sabotaged your ability to respond to the challenges you face? In a book of that name economist Friedrich Hayek called efforts to politically manage prices to achieve desired social outcomes the Fatal Conceit.

Fiscal catastrophe aside, the creation of a central pricing authority is the real tragedy of Medicare. Real prices are set when buyers and sellers execute a transaction. Asking a political committee to set prices, freeze them in amber, then publish them as collusive benchmarks to providers that are supposed to be competing with each other strips out all the valuable information content that is normally carried in a price.

Central pricing with market-moving power through guaranteed payments to large segments of customers creates economic monstrosities like MRI machines that blossom like mushrooms after a rainfall, and geriatric patients that are transformed into cash machines when bankrupt hospitals madly cycle through every HCPCS/CPT code they can justify while there is still a pulse. Central pricing destroys the better, faster, cheaper imperative that helps other industries thrive. Central pricing gives us shortages and surpluses of everything from doctors to vaccines and ultimately necessitates rationing. That’s because every centrally-frozen price is wrong. And if it isn’t wrong now it will be wrong a moment later. Wrong prices can only lead to wrong investment decisions, wrong R&D agendas, wrong supply chain optimizations, wrong treatment decisions, and unhappy customers. How can anyone expect you to successfully manage an industry that represents 16% of our economy when you’ve built your foundation on wrong?

Bill Frezza is a consultant and venture capitalist living in Boston. He is a regular contributor to RealClearMarkets and Forbes.com. Bill can be reached at bill@vereverus.com.